When will the tide turn for emerging market debt?

For the first time in years, real value is opening up in emerging market debt assets.

16/12/2014

James Barrineau

Co-Head of Emerging Markets Debt Relative

30 MinutesUnstructured Learning Time

As always in the run-up to cycles of unambiguously good value though, the price of admission is to witness sharp asset price declines. This is where we are today and are likely to be for the near future. We outline here the factors we think that will determine, within a reasonable range of accuracy, when the value tide turns.

For the first time in years, real value is opening up in emerging market debt assets.

Perhaps the clearest signal of cheapening assets in emerging markets (EM) has been the march downward of the Mexican peso in value against the dollar. This week we passed the lows in nominal value achieved in 2011 - at the height of the European crisis - and began to approach the absolute lows achieved post the 2008 financial crisis. Though it is simplistic to look at only nominal values, real exchange rates - arguably stretched in value for most of this century across EM - are correcting at an extremely brisk rate.

The chart below illustrates that in fact the terms of trade are improving across most large EM countries. This is in contrast to the conventional wisdom; that lower commodity prices equals broad EM crises. A divergence between fundamentals and price action always heralds opportunity.

Higher quality dollar debt has also lagged Treasuries dramatically. We began November with sovereign investment-grade spreads at 190 basis points, and at the time of writing are now at 226 basis points—the highest since January. Given the credit spread rally globally, historical comparisons further back are probably not valid in the current rates environment in developed countries.

If one assumes further easing from the European Central Bank (ECB) and the Bank of Japan (BoJ), and a slow pace of tightening in the US, this will likely be looked at in a few months as representing value against similarly-rated credits. But non-investment grade debt has suffered far worse, with both sovereign and corporate debt offering negative returns for four of the past five months, and price falls of over 5% in the last six weeks.

So what turns the tide? For currencies, the strong dollar story - which was the explanatory variable for months - gave way this month to the generalised risk-off market action. So, the drivers of a stabilisation in foreign exchange (FX) are probably the same as those for dollar debt.

We count those as: a recognisable stabilisation of commodity prices, fundamental growth improvements, and a level of comfort with the future Fed policy framework.

• It is difficult to see commodity prices stabilising in the near-term, but as in every similar cycle, asset price movements are almost certainly going to substantially front-run the fall in actual commodity values. The cure for low prices will be low prices. Lower investment budgets by oil producers are already apparent. However, prices will almost certainly wait for initial signs that lower investment is leading to balanced markets before reversing.

• The second factor - stable to better growth - is necessary to help erase the negative effects of lower commodity prices and sharp currency depreciations on fiscal and monetary policy decisions. A drop in oil prices of the current magnitude almost certainly guarantees better developed market growth and a spill-over into EM, but the breadth and depth of that change will, again, have to be at least glimpsed to begin to be believed.

• Lastly, it seems clear for markets that potential Fed tightening trumps the almost certain ECB and BOJ easing. The Fed’s calculus for weighing lower price inflation against stronger jobs and better growth prospects is unknowable, but at some point within the next 4-6 months a path will be clearer, and the markets will then move forward.

While we wait for clarity, the seasonal illiquidity in markets is conspiring with the illiquidity that is a consequence of portfolio outflows and risk aversion to drive prices sharply lower. On that front, we are hopeful that the turn of the calendar begins a process of bottom-fishing that provides some stability. Timing is thus quite unclear, but the cyclical value opportunity gets ever more certain.

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